Hongkong and Shanghai Hotels (HKG:45) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, The Hongkong and Shanghai Hotels, Limited (HKG:45) does carry debt. But is this debt a concern to shareholders?

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What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Hongkong and Shanghai Hotels's Debt?

The image below, which you can click on for greater detail, shows that Hongkong and Shanghai Hotels had debt of HK$13.4b at the end of December 2024, a reduction from HK$15.9b over a year. However, it also had HK$895.0m in cash, and so its net debt is HK$12.5b.

How Strong Is Hongkong and Shanghai Hotels' Balance Sheet?

According to the last reported balance sheet, Hongkong and Shanghai Hotels had liabilities of HK$9.44b due within 12 months, and liabilities of HK$9.29b due beyond 12 months. Offsetting this, it had HK$895.0m in cash and HK$451.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$17.4b.

This deficit casts a shadow over the HK$9.34b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Hongkong and Shanghai Hotels would likely require a major re-capitalisation if it had to pay its creditors today.

View our latest analysis for Hongkong and Shanghai Hotels

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Hongkong and Shanghai Hotels shareholders face the double whammy of a high net debt to EBITDA ratio (8.9), and fairly weak interest coverage, since EBIT is just 1.1 times the interest expense. The debt burden here is substantial. The good news is that Hongkong and Shanghai Hotels grew its EBIT a smooth 31% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. There's no doubt that we learn most about debt from the balance sheet. But it is Hongkong and Shanghai Hotels's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Hongkong and Shanghai Hotels actually produced more free cash flow than EBIT over the last two years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

On the face of it, Hongkong and Shanghai Hotels's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Hongkong and Shanghai Hotels's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. While Hongkong and Shanghai Hotels didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away. Click here to see if its earnings are heading in the right direction, over the medium term.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.